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Income Investing

Valuations in senior loans and high yield corporates appear disconnected from reality

Larry Holzenthaler
Client Portfolio Manager
Bill Martin
Portfolio Manager
five circle bridge

Investors looking to take advantage of current market volatility face enormous uncertainty. It is impossible to know what toll the coronavirus will take on the U.S. and global economy, how long its effects will last, or how quickly the economy will bounce back following the lockdown of the global consumer. However, certain asset classes may still look attractive as their valuations reflect the direst of outcomes. One such investment appears to be U.S. corporate loans and high yield bonds. At current levels, it appears that deeply discounted assets in these markets may offer investors an attractive potential return opportunity even if the outcome of the coronavirus results in an unprecedented amount of default losses for investors in the coming years. But, active management and deep fundamental credit research remain essential.

Certain asset classes may still look attractive as their valuations reflect the direst of outcomes.

Putting a risk and return framework around corporate loans and high yield

Senior loans and high yield bonds are credit-sensitive assets, so their prices tend to track equities higher and lower. However, they are very different investments. Both loans and high yield bonds have finite lives, with maturities and call dates, versus equities which are perpetual instruments. Further, both senior loans and high yield bonds have what is known as a “recovery value” which refers to what percent of par investors recover in the event that an issuer defaults on their debt.

Because investors know when they’ll get their par back, and can estimate how much they’ll lose if they don’t, they’re able to calculate what is arguably the most important statistic for an investor in the loan and high yield market. It isn’t prices or spreads. It is something referred to as an “implied default rate” or “implied default loss rate”.

The implied default rate takes prices and spreads as inputs and translates that number into what is, in essence, a simple equation that answers the question, “If I invest at these prices and spreads, how much money can I lose as a result of defaults before I would have been better off owning risk-free assets?”

The implied default rate is a very powerful statistic, as it allows an investor to calculate exactly what percentage of defaults an investment can withstand before the holder loses money. But there is one catch: An investor needs to make an assumption of the investment’s recovery value. This is, in effect, how much money an investor recuperates when an issuer defaults. Investors aren’t just concerned with how often an issuer defaults but, importantly, how much money they will lose when that occurs. Specifically, investors are focused not on default rate but rather the “default loss rate.” The default loss rate is an easy equation. It is the percentage of the companies in the market that will default on their debt multiplied by how much money an investor loses in the event of default.

Default Loss Rate = Default Rate X
(1 – Recovery Rate)

Figuring out recovery rates

Two data points can help investors make recovery assumptions. One is historical data. Historically, the average recovery rate on defaulted loans has been 67% of par. It’s a fairly high number and reflects the seniority, security and first-liens that loans typically enjoy. For high yield bonds, which typically have a riskier profile compared to senior loans, recoveries have historically been much lower at roughly 40% of par.

Bar graph

Historical data, however, has limitations as future recovery rates may not be in line with historical recovery rates. It’s probably fair to assume that this is the case today, especially for loans. Structural changes in the loan market, such as more issuer-friendly credit agreements, more “loan only” and “loan heavy” capital structures and credit-quality migration / degradation, result in a situation where recovery rates are likely to be lower in the future than they’ve been historically.

How much lower? The current range of recovery value estimates across various research departments and rating agencies is anywhere from 50-70% for loans and 30-40% for high yield bonds. For purposes of calculating an implied default rate, it is best to assume that recoveries are at the lower bound of current estimates, and consistent with recent observations: 50% for loans and 30% for high yield.

Current implied default rates: a disconnect from reality

While it is impossible to know what the future default and recovery experience will be, even the most bearish forecasts are far more optimistic than current prices and spreads imply.

Assuming a 50% recovery rate for loans and a 30% recovery rate for high yield, current spread levels imply a cumulative default rate for loans and high yield of roughly 35% or more in the coming years. That is significantly higher than at any point in history, including the 2001 crisis and the Global Financial Crisis.

Bar graph

Currently, even the most bearish estimates call for default rates to reach 13% on a trailing twelve month basis later this year and taper off thereafter. So the market is pricing in a much higher level of default losses than even the most bearish investors today are forecasting.

How can prices be so disconnected from reality? A large driver of this mispricing has to do with the forced selling that has occurred in both the loan and high yield market as investors have rushed to raise cash amid the market volatility. When there are too many sellers and too few buyers in a relatively illiquid market prices can often get dislocated. This is sometimes most obvious within individual names.

Take, as an example, the $4B senior secured first lien loan of Sprint Communications maturing 2024. In mid-March this BB-rated loan traded as low as 91-92% of par.

line graph

What makes that level most interesting is that in mid-March Sprint was finalizing a merger with T-Mobile in what is a multibillion dollar transaction. As part of that merger, the loan would be repaid at par. The timing of the merger, and the retirement of the loan, was widely known to market participants and Sprint even went as far as to publically reassure investors in March that the deal would be completed via a press release. By the time the merger was completed on April 1st, the loan had ratcheted to par. Did the seller of the loan, an institutional manager, not know that the loan would be worth par in two weeks when they sold it at a deep discount to par? Likely they did. But they were also likely forced to raise cash quickly and had to sell pieces of all of their liquid positions at prevailing market prices. OTC markets can become extremely inefficient with how they price risk at different points in time.

At today’s levels, both loans and high yield offer attractive income, upside total return potential and potentially lower volatility than other investments such as equities.

What does this mean for investors?

While prices and spreads have recovered from the lows seen in March, corporate credit may be attractive for investors who need to allocate capital amid the current market uncertainty. At today’s levels, both loans and high yield offer attractive income, upside total return potential and potentially lower volatility than other investments such as equities. At the very least, investors should familiarize themselves with the mechanics of investments in both loans and high yield such as recovery values, implied default rates, and their impact on an investors returns. While nothing is certain in today’s market, current spreads in today’s senior loan and high yield market may be more than adequately compensating investors for that uncertainty.

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Bloomberg; J.P. Morgan; Moody’s Investors Service; S&P LCD; Markit


The views and opinions expressed are for informational and educational purposes only as of the date of production/writing and may change without notice at any time based on numerous factors, such as market or other conditions, legal and regulatory developments, additional risks and uncertainties and may not come to pass. This material may contain “forward-looking” information that is not purely historical in nature.

Such information may include, among other things, projections, forecasts, estimates of market returns, and proposed or expected portfolio composition. Any changes to assumptions that may have been made in preparing this material could have a material impact on the information presented herein by way of example. Past performance is no guarantee of future results. Investing involves risk; principal loss is possible.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.

A word on risk

All investments carry a certain degree of risk, including possible loss of principal, and there is no assurance that an investment will provide positive performance over any period of time. It is important to review your investment objectives, risk tolerance and liquidity needs before choosing an investment style or manager. Debt or fixed income securities are subject to market risk, credit risk, interest rate risk, call risk, derivatives risk, dollar roll transaction risk and income risk. As interest rates rise, bond prices fall. The value of the portfolio will fluctuate based on the value of the underlying securities. There are special risks associated with investments in high yield bonds, hedging activities and the potential use of leverage. Below investment grade or high yield debt securities are subject to liquidity risk and heightened credit risks, among other risks. In addition to create and liquidity risk among other risks, loans are subject to settlement risk due to the lack of established settlement standards or remedies for failure to settle.

Nuveen provides investment advisory solutions through its investment specialists.


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